Lend some thought

Microfinance like loans is targeted specifically at such low-income clients and has proven very successful in expanding their access to credit, writes Lucia Wegner.

india Updated: Oct 24, 2006 00:40 IST

There are as many as four billion people living on less than $ 1,500 a year, the so-called ‘bottom of the pyramid’. Not surprisingly, only a fraction of these, including households and micro-entrepreneurs, have access to basic financial services.

Microfinance — loans and other financial products — is targeted specifically at such low-income clients and has proven very successful in expanding their access to credit.

Microfinance institutions (MFIs) include a broad range of financial sector organisations: banks, non-bank financial institutions, financial cooperatives, credit unions, finance companies and NGOs specialising in serving people who lack access to traditional financial services. According to the UN Commission on the Private Sector, 2004, micro-credit schemes and MFIs serve 41 million poor people in over 65 countries.

This is still not enough. The challenge remains to meet the huge, untapped demand in credit for cottage industries and micro-enterprises. These are often ‘unbankable’ — that is, insulated from formal traditional financial markets — and must resort to informal moneylenders.

MFIs are potentially useful for filling the gap in short-term financing and in order to avoid

informal moneylenders. They could also become a source of finance for micro-enterprises and small- and medium-sized enterprises (SME) as well as contribute to the development of financial markets, especially in rural areas and among the ‘unbankable’.

MFIs have, in fact, developed beyond being purely a poverty-alleviation tool to financing economic development through their proximity to local entrepreneurs. Their successful uptake is due to a flexible formula offered to small entrepreneurs, which bypasses stringent regulatory and collateral requirements. For example, Novobanco, active in Africa and Latin America, provides credit to small- and medium-sized companies based on no-fees accounts with no minimum balance, informal guarantees (house assets and a guarantor), and a continued relationship with loan officers.

Short-sighted approach

Despite their adequacy to local needs, MFIs remain small and fragile. They often lack the skills to assess project proposals or to develop or adopt innovative financial tools. MFIs also struggle to follow their clients as they grow. Since they lack medium- to long-term savings, they are inhibited from transforming into long-term lenders.

Furthermore, the refinancing of MFIs through the formal banking sector is limited by a lack of collateral and the cost of financing. Unlike commercial banks, MFIs have no access to central bank refinancing at low cost. And since they are not formal financial institutions, they do not qualify for refinancing through venture capital.

Policy remedies

Agreements between MFIs and providers of non-financial services can ease the former’s capacity constraint. Business Development Services (BDS) institutions can carry out the first selection of project proposals on purely technical substance aspects. MFIs can then assess the financial viability of such projects.

The financial sustainability of MFIs can be strengthened by closer collaboration with formal banks. The consequent transfer of clients to the banks as their financing needs increase is a good example of a mutually beneficial outcome. Associating informal financial organisations and formal institutions can help the former grow closer towards formality.

Specific legal provisions may help MFIs to extend their lending activities to SMEs, mainly by increasing the maximum length of time to loan amount and by extending the maximum loan maturity. Following such changes, many MFIs are already developing into full-fledged rural banks, and are able to finance medium-sized enterprises.

The question is whether MFIs are going to ‘lose their soul’ by pursuing such a growth strategy. If they decide to transform themselves into ‘normal’ banks, who will look after the poor? The answer may still be the MFIs. The drift towards commercial microfinance may provide them with just the stability they need to stay and extend this vital resource for the poor.

Lucia Wegner is Senior Editor of the African Economic Outlook, OECD Development Centre, Paris.

First Published: Oct 24, 2006 00:36 IST